Oil and Alaska’s Economy

Anchorage, AKJune 16, 2016by Tim Bradner

Oil fields on the North Slope have provided huge benefits to our state over many years. The oil companies pay taxes and royalties to the state, which allowed the state to pay for community buildings and schools across the state, and services like Power Cost Equalization and community revenue-sharing.

There was a lot of money coming in, and in 1976 Alaskans created the Permanent Fund, setting aside one fourth of the oil royalties as a savings account. The Legislature later increased this to where it is now about one-third of royalties, and in 1981 the Permanent Fund Dividend was also created so citizens could share in the earnings of the Fund.

Things went well for many years, although there were ups and downs in oil revenues. We are now in another down period, this one very serious. The oil companies are having to cut back and this is affecting companies that do business with the industry. The state of Alaska is also having to cut budgets. All Alaskans are having to tighten their belts. Revenues from oil will improve at some point, but no one knows when. Things are unlikely to get back completely to the way they were, however.

In the meantime, the North Slope oil companies are delaying drilling and development of new projects and asking contractors, including NANA’s companies, to reduce expenses. One company, Caelus Energy, has delayed development of a small new oilfield, Nuna. Another company, Brooks Range Petroleum, is also delayed in completing work on one other field. BP, a major North Slope field operator, has cut its drill rigs from five to two this year. Most important, the large Alaska LNG Project, which would take North Slope gas to market, may be delayed because of the effects of low oil prices on its sponsor companies, the North Slope producers.

Oil prices and oil revenues go up and down, and when they do, the state’s revenues can increase, sometimes sharply, or fall, sometimes very quickly. Oil prices dropped very quickly in 2015 and early 2016, creating a serious financial crisis for the state of Alaska. In recent weeks oil prices have gone up, but very slowly and not enough to help the state’s budget situation. It may be a temporary rise, too. Prices could drop again.

There have been crashes in oil prices before. In 1986, 1998 and 2009 prices dropped sharply. They did recover, and Alaskans survived those periods, although there was pain felt. This time it is different, though. Until recent years there was enough oil production and revenues that the ups and downs of state oil revenues were mostly cushioned by other savings accounts the Legislature has set up.

The exception to this was in 1986, when oil prices dropped to $10 per barrel. The state didn’t have cash reserves then and former Gov. Bill Sheffield had no choice but to cut spending sharply, mainly in construction, or else the state would have run out of money for vital services, like public safety and schools. Those cuts caused a recession in parts of the state. Home prices fell in Anchorage and Fairbanks and people lost jobs. Many people left the state.

Gradually the economy recovered, and since 1988 employment started growing again. Employment grew steadily ever since, except for 2009 when the national recession hit. “It has been quite remarkable, for almost 25 years,” says Neal Fried, an economist with the state Department of Labor and Workforce Development.

During the 1990s the state also saved more money, and when oil prices crashed again in 1998, again to $10 a barrel, state revenues were affected but budgets were stabilized by using savings. The effects were temporary and most Alaskans hardly felt them. When prices fell again in 2009, the impact was also felt lightly.

Meanwhile, the state’s economy was growing steadily. Directly or indirectly, oil fueled much of this growth. Professor Scott Goldsmith, a University of Alaska economist, says oil pays for about a third of Alaska’s economy either directly through oil field jobs or contracting with service companies, or indirectly through the revenues the industry provides the state. Those are spent in state programs and projects, which also create jobs. For the rest of the economy, federal spending, such as the military, pays for about one third and everything else–mining, fisheries, tourism, retail–pays for the other third.

However, oil income is even more important, Professor Goldsmith says, because it has allowed Alaska to have relatively few taxes and has paid for support facilities like airports, docks and harbors. Low taxes and the development of infrastructure has allowed the non-petroleum parts of the economy to grow faster, more than it would have if there were no state oil revenues and there were high taxes. If there was no oil and if Alaskans paid the kind of taxes paid in many others states Alaska’s economy would be about half the size it is now, Professor Goldsmith says.

Why did oil prices drop so quickly?

There is no way to predict world oil prices. It’s comforting to think that someone, somewhere, has control, and big oil exporting nations who formed the Organization of Petroleum Exporting States, or OPEC, used to have a lot of influence. That isn’t the case anymore.

There are new producers who are outside OPEC, like Russia and even the U.S., which has sharply expanded its oil production after oil companies learned to squeeze oil out of tight shale rock. There are also countries within OPEC, like Iraq and Iran, which need money and want to expand production to earn more even if prices drop.

Prices are also affected by oil demand, and in 2014 and 2015 as oil supply continued to expand, demand was leveling off because the economy of China was slowing, as was Europe and Japan, all big customers for oil producing nations. When there is more supply and less demand in an open world market, prices drop. Sometimes they can drop very quickly, too, as happened in the previous price crashes. That’s because there’s also a psychological element to the market.

Oil traders are human, and when they see prices dropping, they often rush to sell so they can get income before the price drops again. This is a vicious cycle because one price drop triggers another. This can catch people by surprise because while economists can study the market and see the broad trends of oversupply and weak demand, they cannot see inside peoples’ minds as they make day-to-day decisions on selling oil.

Or buying oil, for that matter, because the psychological element works the other way too. When prices are rising people often try to buy more oil to get ahead of the market, if they believe prices will continue going up. Of course, that makes it happen. This kind of behavior helps explain the sudden spikes in prices and the unexpected dips.

How long will this cycle last?

No one knows. Oil production is dropping in many places because of low prices. Alaska’s production is also dropping, although that is mainly the natural decline due to the aging of our oil fields. If economic activity picks up in the major oil-consuming nations, like China, the oil market will regain stability and prices will begin to increase. There are signs that this is happening, but it is too early to know for sure. The economic recovery is weak in many places.

The biggest uncertainty, however, is that there is still a lot of oil. Producing companies have cut back production but in many places they have the ability to quickly start up again. That means that as prices rise there will be more supply and if that happens too quickly prices will drop again. Also, there are many countries that are desperate to increase their oil production to stimulate their economies.

Another uncertainty is that there has been a shift in the link between economic growth and oil demand. It used to be that when there was economic growth there was also increased use of oil, because more energy was consumed when the economy grew. That may no longer be as true. Many industries have become more energy efficient, and there are new mileage standards on automobiles and trucks that result in less gasoline and diesel being used. Homes have better insulation, so that less heating oil is needed, and renewable energy like wind power is reducing the amount of diesel needed for power generation. These are good things but they make it much more difficult to predict how much resumed economic growth will result in more oil demand.

Still a lot of oil in Alaska

It is a physical fact that the large oil fields of the North Slope won’t last forever. They are gradually declining. But there is still a lot of oil in Alaska, much of it undiscovered. The new oil fields being found are smaller and do not produce as much as the larger, older fields. But there could be a lot of these and if enough of these are found and developed the decline from the slope could be stabilized.

Economists still believe a recovery to $70 to $80 per barrel is possible in the next two years as the market grows. If oil prices do increase, and, it might be possible to develop some of these medium-sized or smaller oil discoveries. If that happens the oil industry employment and contracting work will improve. However, a return to the boom times when oil prices were over $100 per barrel is unlikely. Some unusual event, like a war in the Middle East, could cause prices to spike, but the effect will probably be temporary.

A gradual improvement in oil prices will help Alaskans who work in the industry but it won’t help the state of Alaska that much. The state’s budget deficit is huge, more than $3 billion a year. Although the Legislature is cutting spending sharply it won’t be enough to help, and they will need to make large withdrawals from our savings accounts. Those savings will soon run out, except for the Permanent Fund. While we can’t spent the Permanent Fund itself (the state constitution bars it) we can use the earnings, which we have not done except to pay for the Permanent Fund Dividends.

Each year the Fund earns $2 billion to $3 billion from investments, which is now more than the state’s oil income. Many Alaskans, including Gov. Bill Walker, believe it is time to use some of the earnings to supplement oil income. If this is done as part of a plan, which could include preserving the PFD in some manner, the state budget could be funded in a sustainable manner, although it would be lower than it is today. New taxes will also be required, however, and the PFD will be lower, because a reduced budget and Permanent Fund earnings can’t cover the gap entirely.

We’ll never get back to the way things were before, when oil production was high and oil prices, and state revenues, were also high. We can stabilize our state budget, and the economy, but the large North Slope oil fields are still declining in production and it’s very uncertain that enough new oil discoveries will be made to stem the decline, at least any time soon. A natural gas pipeline, which is being worked on, could bring in large new revenues but that is at least 10 years in the future, if it is even built.

Still, it won’t rain forever. With the right decisions we can get through this, and things will get better. However, Alaska’s businesses must operate in a leaner manner and our state’s leaders must use our financial resources wisely.

Tim Bradner is co-editor of Alaska, Inc. magazine, co-publisher of Bradners’ Alaska Economic Report and Alaska Legislative digest, and a frequent contributor to the Alaska Journal of Commerce and other statewide and national publications. Tim has been writing about Alaska natural resource projects since 1966.